An appraisal is one of the steps in the home buying process that home buyers are often most worried about – and with good reason. A low appraisal could put your mortgage offer in jeopardy and there's a risk the transaction will fall through. Sellers, too, may wait on tenterhooks to see if the home is worth the agreed purchase price. What happens after an appraisal depends on what the appraisal report says.
After Appraisal, What is the Next Step?
To answer this question, we need to look at the mortgage underwriting process more broadly so you can see how an appraisal fits into the bigger picture. While the mortgage application process varies from person to person, it usually follows a set sequence:
- Preapproval, where the home buyer learns how much he is able to borrow based on his salary and income.
- Purchase agreement, where the buyer and seller agree to a price and sign a contract.
- Home appraisal, where a professional appraiser inspects the home and determines how much the property is worth.
- Mortgage underwriting, where the buyer submits a ton of paperwork and the underwriter decides whether the bank will go ahead with the loan.
- Underwriting conditions, where the underwriter calls for more documents or asks the buyer to satisfy certain conditions before the loan is approved for closing.
- Closing, where money changes hands, the deed gets signed and the buyer gets the keys to her new home.
Purpose of Mortgage Underwriting
As you can see, the next step after an appraisal is mortgage underwriting. The purpose of underwriting is to establish whether the bank wants to make a loan to the borrower, that is, whether the borrower is an acceptable risk. Risk, in this context, means how likely is it that the borrower will default on the loan. For instance, the underwriter will look at the borrower's credit report, debt load, collections history and so on to see if this person has a good record of paying his debts.
Borrowers who are only borderline creditworthy are considered to be a higher risk. They often have a hard time qualifying for loans and if they do qualify, they are unlikely to be offered the best terms.
The appraisal is an important part of the risk assessment process and is one of the nuts-and-bolts documents the underwriter reviews. This makes sense when you consider that the home is collateral for the loan.
Role of the Appraisal
An appraisal is an opinion of a property's value, given by a licensed appraiser. Mortgage lenders insist on them, but cash buyers are often well-advised to get their own appraisal as a way of making sure the home is worth the price they're paying for it.
The reason banks insist on appraisals is to make sure the home is worth as much as everyone thinks it is. If the borrower defaults on the mortgage, then the bank will foreclose and sell the property to get back the money it lent. Let's suppose the bank is lending $200,000. If the appraisal comes back at $190,000 you've got a serious problem, as the bank is going to be out of pocket if they need to foreclose.
In fact, these figures are a little misleading, since banks will always want a buffer between the amount they are lending and the value of the home. This is known as the loan-to-value ratio, which is the ratio between the value of the loan the borrower is taking out and the value of the property as a whole. If you want to buy a house worth $400,000, for example, and have a down payment of $80,000, then you will need a loan of $320,000 in order to purchase the property. The loan-to-value ratio, or LTV, will be 80 percent since $320,000 is 80 percent of $400,000.
More About LTVs
LTVs are significant in the world of underwriting because lenders will have a maximum LTV that they are prepared to approve. Somewhere in the region of 75 to 90 percent is a fairly common upper threshold. If you have the resources to make a large down payment, then you're going to have a lower LTV. Going back to our previous example, increasing the down payment to $120,000 would reduce the LTV to just 70 percent on a $400,000 home.
As a general rule, the higher the LTV, the higher the risk that the lender will lose money if it has to foreclose. With an 80 percent LTV, a relatively small drop in house prices could result in there being fewer sales proceeds than the amount outstanding on the loan. High LTVs translate into higher interest rates to reflect the lender's risk.
On the flip side, a loan with a lower LTV is less of a risk to the lender. This usually translates to a cheaper mortgage product.
How Does This Affect the Appraisal?
When home buyers and sellers look at an appraisal, they tend to be interested in the headline figure – how much the appraiser says the home is worth. If you've agreed to a price of $400,000, for example, and the appraisal says the home is worth $390,000, then as a buyer you're not going to be very happy. Sellers, on the other hand, may be delighted as they're getting more than the market value of their home.
What most people don't realize is that banks care very little about the headline figure – they are more interested in the LTV. Remember our example? Here, the buyer has an $80,000 down payment and needs to borrow $320,000 to buy the $400,000 home. According to the appraisal, that $400,000 home is only worth $390,000. For the bank, the LTV has risen from 80 percent to 82 percent.
Will this impact the bank's lending decision? The short answer is that it depends. If the bank's upper LTV limit is 85 or 90 percent, then it may still approve the loan despite the low appraisal. If the bank's upper limit is 80 percent, then you'll no longer qualify for the loan – or you may need to apply for a different mortgage product based on the higher LTV.
Tying It All Together
What does his mean for home buyers on the ground? When the appraisal comes in, it basically means that there are two possible pathways:
- If the appraisal comes in at or above the contract price, then the transaction will proceed as planned (assuming there are no other issues with the mortgage underwriting)
- If the appraisal comes in below the contract price, you have some negotiation to do. As a buyer you have the upper hand as you can often persuade the seller to lower the price to save the deal from falling through – even if the seller relists the property, they're going to hit the overpay problems at the next appraisal and will have the lower the price to get the home sold.
Remember, you may not have to negotiate the price down to the appraised value, and you could meet the seller in the middle. There's nothing to stop you from paying slightly over the appraised value if you really want the home and have enough cash to make up the difference. The key is to get the LTV to an acceptable level so the bank approves the loan.
- Home Buying Institute: What Happens After Appraisal, and How Long Until Closing?
- Home Buying Institute: How the Mortgage Underwriting Process Works
- Investopedia: What You Should Know About Home Appraisals
- Statista: Average LTV Ratio in the U.S. 2019, by State
- Realtor: What Is Loan to Value Ratio? It's the Key to Getting a Good Mortgage